We'll use rate cuts to fight off threat of a recession, says Bank of England

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The Bank of England yesterday signalled it is preparing to cut interest rates in an attempt to ward off a recession.

Issuing its most gloomy outlook for five years, the Bank said the economy could go into a sharp downturn that would hit over-inflated property prices.

And in a dramatic warning that alarmed the City, Bank governor Mervyn King said that the stock market may be teetering on the edge of a precipice.

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Gloomy: Mervyn King said mortgages will cost more

The bleak predictions in the Bank's quarterly inflation report suggest the impact of the world credit crunch sparked by a U.S. sub-prime mortgage meltdown is only just starting to hit the UK.

While the prospect of the first rate cuts for more than two years will be greeted with sighs of relief, the Bank's outlook suggests homeowners will still have to cope with a painful period of sluggish growth and high inflation.

Economists said a first downward move in the Bank's base rate could come as soon as next month.

Michael Saunders, of Citigroup, said the Bank's forecasts looked to be the weakest since the September 11 attacks, describing them as "stunningly" pessimistic.

"Find a word that describes a pretty grim economic outlook and that is the Bank's base case," he said.

"All this is a very clear signal that the Bank's monetary policy committee expects to cut interest rates if events unfold as expected. They could not be clearer."

Downturn: A downwards ecomony would hit over-inflated property prices

Mr King confirmed his outlook is for a "sharp" slowdown in growth next year to around 2 per cent from over 3 per cent in 2007.

That assumes two interest rate cuts in the next year. The governor's comments sent the pound skidding on foreign exchange markets where it dropped two cents against the dollar to $2.06.

But he did not rule out the possibility that Britain faces its first recession since the early 1990s - a prospect to alarm Gordon Brown.

"In the short run there is undoubtedly a risk, largely from the world economy, of a bigger downturn than in the central projection," Mr King said.

"In comparison with August, the near-term outlook is less benign for both inflation and growth."

At a press conference yesterday, Mr King added: "Compared with the very small movements we've seen in the past ten years, when we have seen a remarkable degree of stability, it looks like a fairly sharp slowdown, though it's not actually that sharp compared with many of the movements we've seen in the past 30 or 40 years.

"The two things that have changed since August are, one, the potential impact of the considerable tightening of credit conditions on domestic demand.

"And secondly, possible slower growth in the world economy, led by a slowdown in the United States."

Mr King said there were question marks over high levels of property prices and company shares.

"You can clearly see some weakening in activity' in the housing market," he added.

Mortgage approvals have fallen back steadily quarter by quarter and some indicators of house prices look "particularly weak".

But he said a property slowdown is no bad thing: "In some ways we very much needed to get away from the period when house prices were rising in double-digit growth.

"We needed a cooling in the housing market. We've seen that. How far that will go remains to be seen."

Mr King predicted that mortgages will be much less favourably priced in the future, as bankers tighten up their lending because of the crisis in world banking.

That is likely to be a "permanent" feature of the mortgage market, which could damage borrowers' incomes and spending, he warned.

The £1.3trillion debt burden held by Britons could act as an additional drag.

The bank said that some two fifths of mortgage borrowers now have secured debts that exceed £90,000, up from one fifth only three years ago.

Among those who have unsecured debts, some 12 per cent are finding them a "heavy burden" the Bank reported. That gloomy verdict was borne out by banking giant HSBC, which said it had suffered a £1.6billion hit to its earnings in the third quarter alone because of rocketing loan defaults in the U.S.

But while Mr King insisted Britain's banking system is robust, he was far less optimistic about the outlook for the stock market.

"It's striking that despite the developments in the past three months, despite stresses and strains in the banking system, equity prices on average are higher now than they were in August," he said.

Rising oil prices and inflation remain major worries, which could inhibit the Bank from cutting rates as aggressively as many homeowners may hope.

"Further financial market fallout, either at home or overseas, poses the biggest downside risk to activity," the inflation report said.

But the impact of that risk on inflation needs to be weighed against the upside risks from higher energy and commodity prices, and from wages and inflation expectations."

The origins of the "sub-prime"

One of the mysteries of the global credit crisis is the origin of the word "sub-prime", now used to describe mortgage loans which should probably never have been made.

Some experts believe the term can be traced back to the Old West and the great cattle markets of Chicago and Nebraska.

Meat traders labelled the finest cuts of beef as 'prime' and the lesser cuts as "choice".

But everyone knew the latter was no more than a kind translation of sub-prime - the cut of beef that no one really wanted.

Prime was adopted by America's bankers to describe the interest rate charged to the most creditworthy borrowers. Anyone else was sub-prime.

 

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